Blog · Finance metrics and formulas · Finance and FP&A teams
Compare accounting ROE with the required equity return supplied by your finance team. A worked company example separates book equity, the hurdle rate and the dollar gap between them.
An ROE cost of equity comparison puts an accounting return beside the return owners require. ROE comes from income and book equity; cost of equity is an assumption supplied or approved by finance. Their difference helps assess company performance, but the two figures measure different things.
ROE asks how much accounting profit the company earned relative to common shareholders' book capital. Cost of equity asks what return owners require for accepting the company's equity risk. The CFA Institute's cost of capital reading defines that required equity return and explains why estimating capital costs involves assumptions and choices.
| Question | Return on equity | Cost of equity |
|---|---|---|
| What is measured? | Accounting earnings relative to common book equity | Required compensation for equity risk |
| Main inputs | Common earnings and average common equity | Finance-approved risk and financing assumptions |
| Time orientation | Usually a completed reporting period | Usually a forward-looking requirement |
| Denominator or reference | Common equity recorded in the accounts | A required percentage, often estimated using market-based assumptions |
| Best use here | Explain reported performance | Set the comparison requirement |
| Main limitation | Accounting choices and financing alter the ratio | The requirement is estimated, rather than directly observed |
Keep the rate-setting discussion separate: cost of equity covers the assumptions behind the required return. This comparison starts with a supplied rate and records who approved it, when, and for what purpose.
ROE = Net income available to common shareholders / Average common book equity
Average common equity = (Opening common equity + Closing common equity) / 2
Accounting return spread = ROE − Required equity return
Illustrative equity charge = Average common equity × Required equity return
Use after-tax earnings attributable to the same common shareholders represented in the denominator. Remove preferred dividends when the starting earnings figure has not already done so. Do not pair subsidiary earnings with the parent's equity or total group earnings with equity that excludes outside owners.
The SEC's guide to financial statements distinguishes income earned over a period from a balance sheet measured at a point in time. That distinction is why an annual profit needs a representative equity balance. Opening and closing equity provide a simple average; material capital changes during the year can require monthly or time-weighted balances.
The comparison also needs one currency and one horizon. An annual nominal USD required return should be compared with an annual USD accounting return. Comparing completed results with a current requirement is possible, but label it as a current assessment of historical performance. It is different from testing the requirement approved before the period began.
The following figures are illustrative for a US operating company. Both years end on December 31, and all earnings and equity belong to common shareholders. The required rates are supplied assumptions, not current market estimates. Dollar calculations use unrounded inputs; percentages below are shown to one decimal place.
| Input or calculation | 2024 | 2025 |
|---|---|---|
| Net income available to common shareholders (USD) | 1,080,000 | 1,540,000 |
| Opening common equity (USD) | 8,000,000 | 10,000,000 |
| Closing common equity (USD) | 10,000,000 | 12,000,000 |
| Average common equity (USD) | 9,000,000 | 11,000,000 |
| ROE: income / average equity | 12.0% | 14.0% |
| Supplied annual required return | 13.0% | 12.0% |
| ROE less required return, percentage points | −1.0 | 2.0 |
| Equity charge: average equity × required return (USD) | 1,170,000 | 1,320,000 |
| Income less equity charge (USD) | −90,000 | 220,000 |
For 2025, average equity is (10,000,000 + 12,000,000) / 2 = $11,000,000. Dividing earnings of $1,540,000 by that average gives 14.0%. The supplied requirement of 12.0% gives a $1,320,000 equity charge, leaving a $220,000 accounting surplus against this particular charge.
The return improved while the supplied requirement fell. Keep those explanations separate in the review: one concerns reported company performance; the other concerns a changed assumption.
Two checks make the table auditable. First, the dollar gap must agree with the percentage spread applied to average equity:
Income − Equity charge = (ROE − Required return) × Average equity
For 2025, 2.0% × $11,000,000 = $220,000. Adding the charge back gives $1,320,000 + $220,000 = $1,540,000, exactly the earnings input. For 2024, the $1,170,000 charge less the $90,000 shortfall equals earnings of $1,080,000.
Second, reconcile equity to the statement of changes in equity. The illustrative 2025 movement is:
| Equity movement | Amount (USD) |
|---|---|
| Opening common equity | 10,000,000 |
| Add: common earnings | 1,540,000 |
| Add: share contributions | 960,000 |
| Less: dividends | −500,000 |
| Closing common equity | 12,000,000 |
Unexplained differences can point to missing distributions, other comprehensive income, currency movements or ownership changes. Resolve those differences before comparing entities.
FP&A can use the comparison to frame a profit and capital discussion. The controller owns the reported earnings and equity tie-outs. Treasury or the finance leader owns the required-return assumptions. Business leaders explain operating changes and capital use.
Run a sensitivity before treating the result as a decision. Holding every 2025 accounting input constant but increasing the supplied requirement to 15.0% raises the charge to $1,650,000. The same company then has a $110,000 shortfall and a spread of −1.0 percentage point.
That sensitivity shows why this spread cannot establish company value. It applies a required return to book equity for a management comparison; valuation needs an appropriate prospective cash-flow analysis. The broader financial ratios guide puts ROE beside other measures, while ROE versus ROI addresses the separate question of whose capital a return measures.
Bring your income statement, equity movement schedule and finance-approved required returns in a file: Covirage maps the columns, and its tools compute and check the figures. The external AI model explains the comparison, with every figure traced to its rows. Create a free Covirage account, which takes about a minute, then set up your business and bring a sample of your own data.
See Covirage for finance teams for the team context.
Finance teams generally want sustainable returns to cover the return owners require. However, historical ROE uses accounting profit and book equity, so a favorable comparison needs checks for leverage, unusual items, capital timing and the assumptions behind the required return.
The required return on common equity is a planning and valuation assumption, rather than an interest expense deducted in arriving at net income. A management equity charge can express that requirement in dollars without changing reported accounting profit.
It means the accounting return is below the supplied equity requirement for that comparison. Investigate whether profit, the equity base or the hurdle assumption explains the gap. One period alone cannot show whether a capital decision will meet its longer-term objectives.